It might sound like an exaggeration, but Nov. 16, 2017, was a day to remember for tax professionals. The day began with the House of Representatives voting on their tax reform plan, and it ended with the Senate tax reform plan moving out from committee and to the Senate Floor. Although there is still potentially a long road ahead, this is a major step in the direction of significant tax reform.
Passing in the House by a vote of 227 to 205, the Tax Cuts and Jobs Act proposes sweeping changes to how both individuals and businesses would be taxed. Some of the more significant changes to individuals involve a reduction in the number of tax brackets and a lower maximum taxable rate on certain pass-through income. Currently individuals are subject to seven tax brackets, ranging from 10 percent of federal adjusted gross income (AGI) to 39.6 percent of federal AGI. Under the bill that number would be reduced to four brackets ranging from 12 percent to 39.6 percent. In addition, individuals would be taxed at a maximum rate of 25 percent on a portion of their pass-through income. Currently, pass-through income is taxed at the tax rate of the individual receiving the income.
Other proposed changes to individual income tax include, but are not limited to: an increased standard deduction, a repeal of the overall limit to itemized deductions, and the repeal of the itemized deduction for state taxes. However, even with the repeal of the itemized deduction for state taxes, individuals will still be eligible to claim an itemized deduction for up to $10,000 of state property taxes paid on real property.
Domestically, corporations would also be subject to significant changes if this bill were to become law. Most significantly, the graduated corporate income tax rate (which effectively taxes all corporations with income greater than $18.33 million at 35 percent) would be replaced with a flat corporate tax rate of 20 percent. However, the new rate would be accompanied by a reduction or repeal of several income tax deductions and business credits. Notably, the Work Opportunity Tax Credit is counted among the list of credits that would be repealed. Although these changes would have a significant impact, they are but a few of the many reforms to corporate income tax proposed in this bill.
In addition to domestic taxes, the way that corporations are taxed internationally would also experience a significant shake-up. Presently, the U.S. employs a worldwide system of taxation for U.S. based companies. Under this system the U.S. has the ability to tax all of a resident’s global income. However, income earned abroad by subsidiaries of domestic corporations is generally not taxed until it is repatriated to the U.S., allowing some taxpayers to defer the payment of tax. In order to avoid double taxation when these foreign earnings are repatriated, foreign tax credits are often available to taxpayers who pay tax in the foreign jurisdiction.
Under the House plan, the U.S. would transition to a territorial system. Unlike a worldwide system, a territorial system only taxes income where it is earned. This shift in tax policy would result in the creation of a dividend-exemption system. The House plan would exempt 100 percent of the foreign-source portion of dividends from subsidiaries of U.S. corporate taxpayers, as long as the U.S. corporate taxpayer owns at least 10 percent of the foreign corporation paying the dividend. Foreign tax credits would no longer be available on income exempt from taxation under this provision. A territorial system would also lead to changes in the calculation of Subpart F income. Among the numerous other international reforms are new laws regarding profit-shifting and base erosion.
The passage of this bill is a major step in the direction of reform for the House of Representatives. However, taxpayers should remember that any major changes to the tax code can have significant impacts on both the way they file and pay their taxes. In the event that tax reform becomes a reality, taxpayers would be best suited to consult with a tax professional to determine how they will be affected. Should you have any questions regarding complex tax issues please contact Steven Miller, alliantgroup, LP’s National Director of Tax, at Steven.Miller@alliantgroup.com.